Since the global financial crisis began, one of the major surprises has been the continued resilience of the U.S. dollar - despite attacks on the "American-style capitalist model," financial sector weakness, and record U.S. government deficit spending. The dollar today represents almost two thirds of the world's official currency reserves. Its holders presumably believe that it will remain highly liquid, relatively stable in value, and supported by prudent economic policies by the U.S. Treasury and Federal Reserve.
Many dollar-watchers have long argued that the dollar will retain this status ad infinitum because there is no viable alternative; any potential alternative would have to be sufficiently liquid to facilitate seamless cross-border investment, trade, and commerce; and the Chinese (who hold the largest share of foreign dollar reserves) would never allow it, since the value of their holdings would drop too much if the dollar were to take a tumble.
But in recent weeks, China has begun to address each of these dollar-forever arguments head-on, taking baby steps on the long road toward diversifying away from the U.S. dollar and moving instead toward the establishment of an alternative world reserve currency.
The signs began to emerge in mid-March, when Chinese Prime Minister Wen Jiabao publicly announced that he was "worried" about China's exposure to the dollar. Shortly thereafter, Zhou Xiaochuan, the governor of the Chinese central bank, released a policy paper suggesting the creation of a "super-sovereign reserve currency" to replace the dollar as a reserve currency over the long run. Specifically, he suggested the creation of a fund, managed by the International Monetary Fund, through which dollars could be exchanged for Special Drawing Rights (SDRs), an IMF-created international reserve asset whose value is fixed by a basket comprised 44 percent of U.S. dollar, 34 percent of euro, and 11 percent of each pound and yen.
The SDR idea drew immediate praise, not only from traditional U.S. antagonists Iran, Venezuela and Russia, (all of whom have been agitating to knock the dollar off its pedestal for some time), but from several other Asian countries, Brazil and several prominent macroeconomists. And it created enough momentum that Gordon Brown added the idea to the agenda for the G-20 Leaders Summit.
Though the final G-20 communiqué made no mention of a new reserve currency, what has happened since the meeting demonstrates that the issue remains a live one. Funding increases for the IMF, promised at the G-20 summit, are set to come from two sources: a $500 billion increase in outright funding to the IMF from several member states, and a significant increase in SDR issuance to the tune of $250 billion. While the SDR increase is not likely to have much of an effect on the world's currency markets, it is the first $500 billion that could spark interest among dollar-watchers. Nothing official has been announced so far, but it is rumored that the Chinese will suggest that their contribution of $40 billion could take the form of a purchase of SDR-denominated bonds issued by the IMF. Should this be the case, China would instantly create a AAA-rated, highly liquid SDR denominated instrument that could be traded anywhere in the world.
China has also begun to indicate that it hopes to someday make the yuan an internationally accepted currency in its own right. In the weeks surrounding the G-20 summit, China entered into almost $100 billion of currency swap agreements with trading partners as diverse as Argentina, Indonesia, South Korea, Malaysia, Belarus, and Hong Kong. That means that trade between these countries and China is likely to take place more and more through the easiest and most cost-effective means of settlement: the yuan -- not the dollar.
Of course, these are small steps, and the dollar is not likely to be replaced anytime soon. But, it would be wrong to simply assume that the currency's dominant reserve position will remain unchanged forever -- a point that China's recent words and deeds should make clear.
There's nothing sinister here: China, in exploring alternatives to the U.S. dollar, is merely acting to protect its economic and financial interests. But, with finance and foreign policy traveling in increasingly overlapping orbits, it's best that we not take anything for granted. History demonstrates time and time again the relationship between the ability to print the world's reserve currency and global political influence.